How to Play Video Game Stocks

Options action shows speculative players

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Despite data to the contrary, option investors are starting to warm to the prospect that holiday shopping season might not be as bleak as previously forecast. This is especially true in the video game sector.

Both software game makers Activision (ATVI) and Electronic Arts (ERTS), and retailers such as GameStop (GME), have seen an improvement in stock price and an increase in speculative call buying.

This morning, shares of Activision jumped 4.2%, or $0.50 to $12.29, and option volume was running two times the daily average. The notable trade was the January $14 calls in which 5,000 contracts were lifted at the $0.50 asking price.

Prior open interest was just 544 contracts, so this looks to be fresh buying. The October $12 calls have seen volume of 4,300 contracts -- mostly in 50 to 100 lot transactions -- primarily in two-sided trade, so some of this might simply be people rolling out of their near-term calls to the longer-dated January series. If you are bullish, it would make sense to own options that will encompass the all-important holiday selling season.

The action in Activision today comes on the heels of last week's move in GameStop which, on Friday, saw shares jump 5% to a three month high of $27 a share. What was more interesting was the surge in call buying, especially in the September $27 and $28 strikes which had just one day until expiration. This action seemed to be driven by rumors that Best Buy (BBY) might be eyeing GameStop as a takeover target.

While those lottery tickets didn't work out, there's still a growing increase of interest in the October $27 calls which have traded another 2,200 contracts today and have seen open interest double to 14,000 contracts in the past four trading sessions.

Where's the Catalyst?

The action in GameStop seems more rational with a potential takeover as a definitive price catalyst. The environment for takeovers has certainly improved in terms of both velocity and premiums paid, witness this morning's Dell (Dell) for Perot (PER) for an all-cask 65% premium. And a Best Buy-GameStop combination certainly offers benefits such as consolidation that leads to market share increase, synergies that result in cost cutting, and the ability for further targeted expansion -- such as kiosks within electronics departments of larger retailers.

This stands in contrast to the software or game makers who have no major titles set for release or new consoles planned for this season. But one positive is that price cuts on game platforms such as Sony's (SNE) PlayStation and Microsoft's (MSFT) X-box have jump-started sales of consoles and might have collateral effect of boosting sales of the games.

Going with GameStop

The strategy I'd consider in GameStop is to sell a put spread for a credit and use the proceeds to help finance the purchase of some calls. For example, selling the November $26/$24 put spread for about a $0.70 credit. This is moderately bullish and will only lose money if shares are below $25.30 on the November expiration. The maximum loss is $1.30 if shares are below $24 on expiration. But the real upside will come through the purchase of the November $28 calls for $170 a contract. So the net cost of the calls is just $1, and this provides unlimited upside exposure.

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